A final thread on the exchange rate. It is slightly pointy-headed again but covers the real effective exchange rate (REER) and how it is commonly misinterpreted in Pakistan. Shout out to @MoazzamIlyas4 who asked for it last night. If u don't like this thread, u can blame him 🤪
First some terminology (with some basic math).
1.The “bilateral exchange rate” is the price of the Rupee against another currency. For instance, the bilateral exchange rate against the US dollar these days is around 260.
1.The “bilateral exchange rate” is the price of the Rupee against another currency. For instance, the bilateral exchange rate against the US dollar these days is around 260.
This means that 1 US dollar is worth 260 Rupees. Similarly, the bilateral exchange rate against the Euro is 280, against the pound is 320, against the UAE dirham is 70, and so on.
2.The “nominal effective exchange rate” (NEER) summarizes the bilateral exchange rates against each currency into a single number and is therefore a better representation of the strength of a currency in international markets.
NEER is all the bilateral exchange rates of the Rupee weighted by how much trade we do with that country. For instance, if we only traded with the US and UAE, and 70 percent of our trade was with the US and 30 percent with UAE, the NEER today would be = 260*.7 + 70*.3 = 203.
3.The NEER is converted into an index that equals 100 at a given point in time. 100 has no special significance other than it being the value of the index at that time.
For instance, we could set the index to 100 today. And if tomorrow, the PKR depreciates to 280 against the USD but appreciates to 60 against the UAE dirham, then the NEER would have depreciated to 280*.7 + 60*.3 = 214.
Since 203 was indexed to 100, the index value of 214 would be (204/203)*100=105. So we would say that the nominal effective exchange rate has depreciated by 5%, i.e. (105-100)*100.
4.The “real effective exchange rate” (REER) is the best representation of how competitive the Rupee is in international markets. It reflects the cost of our exports abroad by adjusting for any change in their prices in Pakistan.
REER is the NEER adjusted for the difference between inflation in Pak&that in other countries. For instance, if Pak only traded with the US and our exchange rate depreciated from 260 this year to 300 next year, it would represent a nominal depreciation of 15%=(300-260)/260*100.
However that would not mean that Pakistan’s goods are now 15% cheaper in the US. Say US inflation remained at 2% this year and next but our inflation increased from 5 to 10%, then in “real” terms, our goods would only have become 10% cheaper in the US = 15-(10-5).
5.This illustrates a v imp concept: if your exchange does not depreciate against another currency by as much as your inflation rises relative to that country, you will lose competitiveness, i.e. your goods will become more expensive there.
At a minimum, therefore, you should expect the Rupee to depreciate every year by how much inflation in Pakistan has gone up relative to other countries (given historical patterns, unless we bring out inflation down, this is around 5-10% a year).
6.Again, the REER (like NEER) is expressed as an index that equals 100 at a given point in time. Again, 100 has no special significance other than it being the value of the index at that time.
A common mistake people (including, believe it or not, our current Finance Minister) make is to assume that a REER value of 100 represents the fair value of the Rupee. That is totally wrong. If there is nothing else you remember from this thread, please just remember this !
7.The REER on its own tells u nothing about where the Rupee should be. As explained yesterday, a currency’s value is determined in the short run by demand&supply, and in the long run by inflation, productivity, demographics, interest rates, the current account&financial inflows
(5) control our current account deficit (higher exports), and (6) generate more foreign currency inflows into Pakistan in the form of FDI, foreign borrowing by banks and the private sector, and foreign inflows into our government debt and equity markets.
@jnasir2 @MoazzamIlyas4 As a result, our foreign exchange reserves fell dramatically. Imports shot up, exports fell. Those are all signs of overvaluation.
@jnasir2 @MoazzamIlyas4 But the REER being above 100 does not in itself tell u anything about overvaluation. For that u need to see if REER is stronger than its equilibrium value. The equilibrium value of REER is determined by the factors in point 7 of my thread & could be anything: 18, 44, 145 …
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